Why Can’t We Be Friends? The Downgrade of the US Credit Rating
Why Can’t We Be Friends? The Downgrade of the US Credit Rating

On August 5, 2011, one of the most groundbreaking events in American economic history took place when Standard & Poor’s (S&P) downgraded the United States’ credit rating from AAA to AA+. Once considered an improbable possibility, S&P set a precedent that, since the financial crisis, no sovereign is safe in the new economic order. However, the ramifications of the downgrade should not be taken as a premonition of an impending crisis.

The US economy is still the largest in the world. Given its size, the U.S. “has ample taxing power to repay its bonds, and its central bank…can as a last resort simply print the money needed.”1 Therefore, it is extremely improbable that the U.S. will default on its debt for economic reasons. U.S. Treasury bonds are still considered one of the safest investments in the world.2 Given this, why would S&P still decide to downgrade US credit? To understand this, one needs to explore the process of analyzing sovereign credit risk.

Sovereign Credit Risk

Simply defined, sovereign credit risk is a “government’s willingness and ability to service debt in a timely fashion and in full.”3 The first part of this definition, the willingness, is a rather significant aspect. Since “sovereigns are not subject to legal restrictions, such as national courts, bankruptcy laws, in the same way private companies are,”4 they have a higher risk to voluntarily default on their debts. So while a country may have the ability to pay, they may choose not to for a number of reasons. For example, if a country ran up high debts during an authoritarian regime, a new democratic government may consider the debt illegitimate and choose not to pay it.

As a result, rating agencies must look at various factors beyond the pure economic strength of a country. For example, Moody’s separates its analysis into four distinct categories. In addition to economic strength, they also investigate institutional strength, government financial strength and susceptibility to event risk. For instance, credit rating agencies will use the World Bank governance indicators to rate the institutional strength of a country.

Once all of these factors are graded, the agency then assigns a rating to the country that helps investors decide whether or not bonds in that country are a reasonable investment. Given these facts, if the economy is not the issue, then which one of these factors caused the downgrade of the US credit rating?

Causes of the Downgrade

Some speculators are interpreting the downgrade as a “wake-up call about our runaway debt” following the battle in Congress over the debt-ceiling and the ensuing deal.5 According to many sources, this is an extremely misleading interpretation. The main reason for the downgrade involved “the reckless and divisive battle that preceded” the deal.6

After the manner in which the deal was handled, S&P concluded that US governance and policy-making had become less stable, causing the downgrade. Therefore, the agency was not questioning the U.S.’s ability to pay its debt, but instead its willingness. It is interesting to note that originally, S&P had provided suspect analysis that actually “overstated cumulative deficits by some $2 trillion, inflating the debt by 8% of GDP in 2021.”7 Although after correcting the mistake, they still downgraded the U.S., adding more weight to the “political brinkmanship” that preceded the debt deal.8

The general inspiration was the fact that the Republicans were willing to use voluntary default as a political tool. Instead of exercising responsible politics, the parties used toxic tactics to get their way. Even after the downgrade, the proverbial “blame game” continued as Democrats referred to it as the “Tea Party Downgrade” while Republicans called it “Obama’s Downgrade.”9

International Reaction to Downgrade

Given the significance of the downgrade, reactions from countries around the world were almost immediate. China, the number one foreign holder of U.S. debt, was both the most vocal and disparaging concerning the events. Upon fears that their holdings could be devalued as a result, Chinese officials claimed that the US needed to “cure its addiction to debts.” In addition, they “called on Washington to make substantial cuts to its ‘gigantic military expenditure’ and its ‘bloated social welfare’ programs.”10

Certain analysts called China’s rebuke “irresponsible”, citing that, “[t]his is a moment for enhance co-operation…not theatrical remonstration.” 11 Other officials tended to agree with this sentiment. French finance minister, Francois Baroin, emphasized his confidence in the US economy, while still stressing the importance of “lift[ing] growth and reduc[ing] public and private debt,” in the developed world. In addition, the Prime Minster of Australia maintained that people shouldn’t overreact, while a magazine in Germany referred to it as “a public humiliation.” 12

Effects of Downgrade and Conclusion

The short term effects of the downgrade became readily apparent with the volatility of the stock market the following week.13 In addition, some analysts posit that it could “raise bond yields and stir exaggerated alarm.”14 Congress has already taken action by forming a joint committee that is tasked with cutting the budget deficit by $1.5 trillion over the next 10 years.15 However, while these short term effects take place, the long term results of the downgrade should be a call to arms within the Federal government.

The government should take this as a sign for more cooperation in the future. Politics have recently turned into too much of a zero-sum game, where one side becomes so desperate to get their way that destroying the credibility of the other side comes at the cost of the greater good. This is a dangerous path, and the precedents that have been set should be wiped clean to prevent further catastrophe.

Cooperation and compromise are needed in order to build a more stable system. For example, while one side wishes to cut spending and the other to raise taxes, they do not realize that both are necessary in order to put the recession behind us and continue on a path of sustainable growth. Finally, as the largest economic power, the U.S. should be a beacon for the rest of the world, not an example of what not to do.

1 “America’s Downgrade: Substandard and Poor.” The Economist. August 13, 2011.
2 “Time for the US to take Decisive Action.” The Financial Times. August 7, 2011.
3 Torres, Gabriel, “Country Risk: What is it Good For?” Presentation, April 6, 2011. Seton Hall University
4 Ibid.
5 “S&P’s Credit Rating Cut: Downgrading Our Politics.” The Economist. August 6, 2011.
6 Ibid
7 “America’s Downgrade: Substandard and Poor.”The Economist. August 13, 2011.
8 “America’s Downgrade: Looking for Someone to Blame.” The Economist. August 13, 2011.
9 Ibid
10 Barboza, David. “China Tells US it Must ‘Cure Its Addition to Debt’.” The New York Times. August 6, 2011.
11 “Time for US to Take Decisive Action.”The Financial Times. August 7, 2011.
12 Alderman, Liz. “Some Concern Abroad About US Downgrade.” The New York Times. August 6, 2011.
13 Hill, Patrice. “Dow Jones Average Plunges 635 Points.” The Washington Post. August 8, 2011.
14 “Time for the US to Take Decisive Action.”The Financial Times. August 7, 2011.
15 “America’s Downgrade: Looking for Someone to Blame.” The Economist. August 13, 2011.

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